Thesis:U.S. Bancorp (USB) has a strong balance sheet, an appropriate mix of business segments, it consistently generates lots of free cash flow, it is trading below its intrinsic value, and it has room for continued earnings growth if/when interest rates rise.

Valuation:By discounting cash returned to shareholders (dividends plus share repurchases), USB is worth $61.69 per share, 37.7% more than its current market price. In 2014 and 2013, USB returned 72% and 71% of earnings to shareholders (dividends and share repurchases), respectively. In 2013, the company stated its target was to return 60%-80% of earnings to shareholders annually, and this target has come down since pre-financial crisis (for example, in 2006 USB stated their goal was 80% per year). Discounting this cash returned to shareholders using a discount rate of 5.75% (weighted average cost of capital) and assuming a 2.0% perpetual growth rate (USB grows at about the same rate as the economy), yields a valuation of: ($5.85 billion [2014 earnings] X 70% [% of earnings returned to shareholders]) / (5.75% - 2%) = $109.2 billion. Since there are approximately 1.77 billion shares outstanding, this results in a valuation of $61.69 per share. And potentially more if interest rates rise allowing USB to achieve additional growth from a higher margin on deposits.

U.S. Bancorp’s Business: - Appropriately Diversified:Headquartered in Minneapolis, Minnesota, the business of U.S. Bancorp (aka US Bank) is appropriately diversified. The company has chosen to operate across four main market segments, and the company’s revenue generation is balanced between margin and fee businesses. USB CEO, Richard Davis, believes USB operates in “precisely the markets where we compete the best, and we are confident this mix of businesses has us well positioned for the future.” (2014 Annual Report). The four main business segment are: Consumer and Small Business Banking; Wholesale Banking and Commercial Real Estate; Wealth Management and Securities Services; and Payment Services. Consumer and Small Business Banking is the largest generating around 39% of net interest income and 28% of non-interest income. In 2014, USB’s interest income (taxable equivalent basis) was $11.0 billion and its noninterest income was $9.2 billion. Consumer and Small Business Banking is largely regional, Wholesale Banking and Commercial Real Estate as well as Wealth Management and Security Services is national, and Payment Services and Global Corporate Trust is international.

Relatively Safe:U.S. Bancorp’s business is relatively safe, providing the company favorable funding costs, strong liquidity, and the ability to attract new customers. For example, the company consistently receives credit ratings among the highest in the industry. USB already exceeds advanced Basel III risk weighted asset ratios as if they were already fully implemented. The company’s debt-to-equity ratio has come down considerably in recent years (from over 3.0 to under 1.5, driven in large part by regulatory requirements), and while this also reduces the bank’s earnings power, it also significantly reduces the bank’s risk.

Additionally, USB’s business mix (i.e. multiple business segments and the split between interest and non-interest income) provides a consistent income stream that can weather a variety of market conditions. Further, Global Finance Magazine ranked USB as one of the World’s safest banks in 2012, 2013 and 2014. And in February 2015 USB was named Fortune Magazine’s Most Admired Super-Regional Bank for the fifth consecutive year. This relative safety helps USB to consistently deliver results.

Growth:USB has multiple sources of potential growth including expanding margins, growing business segments, and simply increasing business as the overall economy grows. For example, interest rates in the US are expected to increase within the next year; this will allow USB to earn a higher spread on the rate they pay depositors and earn from borrowers. Also, USB has opportunity to grow non-interest income (currently roughly 46% of income) by increasing revenue especially from credit and debit card services as well as merchant processing services. Further, USB’s non-interest income should grow in general as the economy grows.

Risks:Major risks for USB include increased government regulations and the possibility that interest rates do not increase in the foreseeable future. Regulatory reserve requirements have dramatically reduced leverage (and risk) in the banking industry, however these regulations have also reduced the earnings power of the banks as well as their ability to return capital to shareholders as they see fit. If regulators were to increase or tighten requirements this could have an adverse impact on USB’s ability to earn profits. Regarding interest rates, USB will not be able to grow earnings as quickly if interest rates do not start increasing in the next year as the US Federal Reserve has indicated they will. Low interest rates have compressed margins for USB (and banks in general), and without raised rates and margin expansion USB’s earnings growth will be challenged.

Conclusion:U.S. Bancorp (USB) is relatively safe compared to banking sector peers, and has demonstrated the ability to consistently deliver profits in good and bad market conditions. Our discounted cash flow valuation model indicates the stock price is below its intrinsic value. Additionally, a rising interest rate environment increases USB’s earnings power and provides additional upside to the stock price. We value USB at $61.69 per share, and rate the stock a “Buy.”